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Emerging markets are, in essence, a leveraged way to play the bet that the Federal Reserve will continue its quantitative easing policy – always, everywhere and forever. Whether that makes them a good investment is an entirely different question.

James Saft, Reuters Columnist

If you believe that the European Central Bank has taken euro break-up off of the table and that the Fed’s pledge to continue buying bonds indefinitely until labour conditions improve will work, then expect fantastic returns from risk assets, and the riskier, as in emerging markets, the better.

There is, however, a more nuanced debate to have. Even if we don’t believe that QE3 will “work” by the Fed’s own definition, we may well expect that it will have a real and positive impact on asset markets for at least some portion of time. By buying relatively safe mortgage debt – and very possibly more Treasuries later – the Fed will put cash into the pockets of investors, cash which will need to find a home.

Some of it, clearly, has been flowing into emerging markets stocks, bond and currencies.

“Powerful policy puts by the ECB and the Fed have, at least in the near term, broken the stress-intervention cycle which has dominated markets for some time,” wrote Piero Ghezzi, head of economics and emerging markets research at Barclays Capital, in a note to clients.

Between the ECB, Fed, Bank of Japan and other central banks, we have a clear game of competitive currency devaluation going on, and it will only become more intense if economic conditions get worse. This could be quite bad for emerging markets…

“While the timing of a global growth rebound remains uncertain, the tail risks for investors, in particular those related to the euro area, have been reduced. This improves the outlook for risky assets and should support flows into EM assets,” he added.

Emerging markets shares have outperformed the S&P 500 in the past month, rising by more than 4% against 2%, during which time the ECB has taken action and the Federal Reserve instituted its new policy of open-ended quantitative easing. Over the past year, however, emerging markets have returned less than half the 23% gain of the S&P, and over two years the figures are deeply ugly, with emerging markets down by 5% against a 25% gain in the S&P.

The Three

There are at least three large risks to a strategy of plunging into emerging markets to play the QE3 momentum trade. First, we don’t know how long the positive effects will last. As in recent bouts of QE, the clear pattern has been for an initial quite positive reaction in markets, but an ebbing over months, especially if economic data does not improve. Returns from past easings have been diminishing over time.

It may well be that you get a nice ride upwards, but an equally magnified or greater fall if markets don’t keep faith with central banks.

Also, you have risks that are particular to emerging markets if QE does work. It may well drive up commodity prices, as it has in the past. This is especially inflationary in emerging markets where poorer consumers spend a higher percentage of their money on food and energy. That’s not just bad news from a human perspective; it may force central banks in emerging markets to keep conditions tight to fight inflation, hurting growth there in comparison to developed markets.

One of the points of QE, though not one officials emphasise, is to help growth in the countries where it is being done by driving down their exchange rates. Between the ECB, Fed, Bank of Japan and other central banks, we have a clear game of competitive currency devaluation going on, and it will only become more intense if economic conditions get worse.

This could be quite bad for emerging markets, which are more dependent on exports and have less well developed domestic consumer economies.

Finally, the big one: the Fed and the ECB may not succeed, and even if they do, politicians here may mess things up by sending the US over the fiscal cliff. The International Monetary Fund warned on Thursday that emerging markets are increasingly vulnerable to another recession in the US or Europe.

“There is no guarantee that the relative calm emerging economies have enjoyed over the past two years will continue,” IMF economist Abdul Abiad said at a news conference. “There is a significant risk that advanced economies could experience another downturn, and in such an event, emerging economies and developing economies will end up ’recoupling’ with advanced economies.”

What the IMF calls ’recoupling’ would look very much like a bloodbath in financial markets, with emerging markets seriously underperforming.

None of this eliminates the value of emerging markets as a source of potential diversification, and as a means to investing in economies which should, over time, grow more quickly than developed ones. But rather than a bet on decoupling, playing emerging markets today needs to be recognised as just a QE trade with booster rockets.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)